Thursday, November 11, 2010

EarthLink: Low P/E, But Diverted Earnings

Earthlink (ELNK) is an Internet Service Provider that trades with a P/E under 4! In addition, the company has very little in the way of debt compared to its cash flow.

Companies will often trade at ridiculously low P/E's due to either a short-term or a long-term issue. Value investors love instances of the former, since it creates a long-term profit opportunity. Unfortunately, Earthlink appears to be an example of the latter, as its business is in secular decline. Nevertheless, the company's P/E is so low that some value investors may be compelled to invest despite the declining industry Earthlink's main business faces.

How can a company in the internet services industry be in decline? Well, Earthlink's major business line is dial-up internet access for US consumers. It doesn't take a clairvoyant investor to realize that broadband internet is rendering dial-up obsolete, at least in this part of the world. The company's revenues over the last four years bear out this problem, as they have steadily fallen from $1.3 billion in 2006 to just 724 million in 2009.

But the company has managed to cut costs in the face of this decline in revenue, as administrative costs have fallen from $770 million to $230 over this same period. Perhaps some value investors would be willing to overlook such declines when the asking price (a P/E of 4) is so low.

Unfortunately, most of the company's earnings are being diverted to other endeavours. While the company does pay a yield corresponding to 7% of its current stock price, that represents only a fraction of the company's earnings. Management appears intent on spending the rest of it on acquisitions that keep the company alive. Following what is effectively a $500 million acquisition (which is half of the company's market cap!), management had this to say on the company's latest conference call:

"After this transaction our company will still be highly unlevered. Our strong balance sheet and ongoing future cash flow will provide us an expanded set of organic and strategic alternatives."

That's fancy wording for "we're probably going to keep throwing good money after more acquisitions". Perhaps these acquisitions will be highly successful, or perhaps they will fail miserably. But value investors don't want even bets of this type. As such, there doesn't seem to be much reason for shareholders of such ilk to get involved, despite the extremely low P/E.

6 comments:

Hi Saj,Really enjoy your blog. I have a question that is a little off-topic. I have been investing as a hobby for the past year and one thing I have struggled with is finding stock screeners to help generate ideas (beyond just basic P/E, P/B screeners available from yahoo finance, wsj etc). How do you generate stock ideas and do you use any screeners?

I couldn't disagree more. The CEO and his new management team have done an A+ job with the dial up business. They inherited New Edge and have, for the past 3 years, been looking at all options including growing New Edge or rolling up other dial-up co.'s. Fortunately, the asking price for the dial-ups were too high. They have shown extreme discipline and now have bought a company that leverages their existing platform at New Edge as well as being able to spread the fixed costs associated with the dial-up business ensuring that this division will continue to throw off a ton of cash for years to come. On top of that, they now own over 14,600 miles of fiber optic lines in the south east and also have some huge accounts that can now be vertically integrated into New Edge. They will have no net debt by end of 2011 and will be kicking out $150 to $200mln in Free Cash against a little over 108 million shares. This is one of the best risk - rewards out there and a great hedge in a weak economic climate. I like your site, but if you're going to post, do your homework.

Those comments are fair and it is a testament to Saj's site that he posts all views (even negative ones from a fellow Canadian -- ).

However, if you read Saj's post, it is quite light on the bear argument for the acquisition or the current businesses at ELNK.

Unlike Berkowitz and Einhorn who have argued extensively, albeit indirectly with each other, with a comprehensive fundamental analysis to back up their opinions. I'm merely pointing out that this one was light on analysis.

Pardon my terse initial response. I shouldn't have included that last sentence.

Most of my ideas come from screeners, or low lists (e.g. 52 week lows) or from reading about and/or hearing from other value investors. If you read a lot and keep your ear to the ground you will hear about a ton of potential value stocks.